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Principled Performance

Have you looked at clients' allocations to the financial sector lately? As the equity and bond markets digest years of mortgage and structured securities-related exuberance, investors may wish to pay close attention to allocations in the financial sector, or at least know what they own--directly or indirectly. For the past several years, financials, which are so tied to the U.S. economy and investing benchmarks, have been difficult to avoid.

There are some mutual funds that generally do not invest in the financial sector because of religious reasons; paying or earning interest is prohibited under Islamic religious principles, as are investing in alcohol, gambling, and pornography. Principles aside, it is hard to argue with the consistent, long-term performance achieved by Nicholas Kaiser, president of Bellingham, Washington-based Saturna Capital, and portfolio manager of the no-load $560 million Amana Growth Fund (AMAGX), and $250 million Amana Income Fund (AMANX). Both funds are compliant with Sharia, or Islamic religious law; "Amana" in Arabic means trust (there's no relation to the appliance manufacturer).

Amana Growth has earned five-year annualized total returns of 21.56%, and Amana Income returned 20.32%, versus 14.64% for the Standard & Poor's 500 for the period ending July 20. S&P gives both funds its overall five-star ranking.

How is investing according to Islamic principles different?

It's significantly different because of the restrictions that we have from investing according to Islamic guidance. Probably the best way to think about that is this week when interest-related stocks--finance companies, banks--have had a rough week.

None of that affects us because we have companies that are really out of anything that has to do with interest. That's our biggest actual screen: banking--companies that make money from lending money are our biggest prohibition.

Does that include other financial-related companies--mutual fund companies, brokerage companies, insurance companies?

We have to look at each one. We have a screen that says no more than 5% of their revenues can come from 'haram' or prohibited activities. Brokerage companies actually make a lot of money from margin interest, sometimes 40% of their revenues can come from [it], so that's clearly out. Insurance companies often make a lot of money from bond operations, so those are out. Some companies might not have those kinds of revenues [though they are] in those industries, and that would be allowed, so we have to look at each company, but in general, no banks, no insurance companies, no brokerages; any company that's using a lot of leverage, basically.

And that's on a lending basis or on an interest-earning basis?

I was talking to a couple of scholars and one said, "You know, Nick, I'd really like to see your portfolio not have any companies with any outstanding debt." And I said, "Well I just happened to screen the S&P 500 for that and there are 36 companies that have no debt." Companies like Microsoft, for instance. He said, "Well, that would be good, that would be the kind of company that you should get." And the other scholar said, "Well you know, companies that have a lot of cash, they tend to earn interest on those deposits." And I said, "Well, yes, and that will eliminate those 36, because Microsoft has a lot of cash." So, that got us down to zero. So you have to think about this, and talk about it. It's not an absolute prohibition because in American business it's impossible not to have interest. We say: "Is that their primary business? Are they in the business of making money from money?"

[In] Microsoft's case, their business is software and hardware development, computers. The fact that they've amassed a lot of cash--it's not a business, they're not planning to make money on the interest and tell everybody how rich they are from the interest earnings. They do have the cash and they use it for corporate purposes such as a takeover or buying something new--that's totally okay because that's just part of their regular business activities, and Microsoft does buy other companies.

But if it's something in their primary business...let's take a retail company: Target. We had Target in the portfolio, and then we found that they were selling lots of wine, and starting up another business of selling wines in some of their stores. So we had to sell that, because alcohol is one of the things we don't do; revenues from activities such as gambling, pornography--those kinds of things are also prohibited. That keeps us out of many hotel chains, which [may have] casinos as part of their business. We screen about 5,000 stocks and about half of those fail. (For more on how Islamic scholars help guide Kaiser in the investment process, see the Web Extra at www.investmentadvisor.com.)

The lack of banking, and firms that lend or earn interest from lending, in the portfolio has been a happy coincidence.

It may clearly be part of the reason why we've been outperforming for the last several years. Generally in the financial sector of the market, when interest rates have been rising it squeezes the margins for those that are operating in the interest world--let's say banks. We don't have those, and interest rates have generally been rising over the past several years and that has probably helped our performance relative to other funds.

What's your investment process for the Amana funds?

We have a universe of 5,000 companies that we screen through, and about 2,500 companies pass the screen. We're value investors at Saturna Capital so we basically look for solid earnings. In the Growth Fund we look for more growth, obviously.

In Amana Income we're interested in a solid dividend. Amana Income is the hardest one to invest because dividend companies tend to employ a lot of debt. The mature companies like utilities may have a lot of financial constructions on their balance sheets that keep us out of them, so it's harder to find qualifying companies, which means we do things like cyclicals, [which] have been a big part of our success there; companies that may be a little riskier because of that. We do have some utilities, we have healthcare, which are the bigger pharma-type companies. Transportation companies would pay a dividend and qualify. Then we just look for solid growth, really, growing earnings that we think would continue from solid business.

What else are you looking for in a company?

We're really looking at the history, the record. I think a lot of investors tend to buy the story; we tend to look more at what they own and how it's done, so past history more than future story. Enron was a company that did qualify in the Income Fund, twice, back in the '90s, but when their debt levels got to be higher we sold them, so we actually made a profit, twice, in Enron. Even though they were lying about the financials, we still got out of them because we could see that the debt was getting to be too high.

Saved by the [investing] principles?

That's right. It does have advantages. In investing, success is helped by keeping away from the losses. If you can avoid the big losses and blow-ups and troubles you tend to do a lot better. Investing, especially with a portfolio, is how the whole portfolio does, yes; you can have some winners and some great stocks in there, but always trying to think you're going to hit a home run is a risky game. We tend to look for, maybe, safer companies--especially in the Income Fund--we're not looking for something to double in two years; that would be a little too risky because the objective is capital preservation and current income, as opposed to just appreciation. Now, it turns out that since we have to buy stocks, the appreciation has been there, but that's kind of a bonus to the objective of the [Income] Fund. So, therefore, more mature companies, bigger--things like AT&T [T], and Alcoa [AA], are in the portfolio. Burlington Northern [BNI] turns out to be a big winner for us; we have some big oil companies.

Railroads are a pretty good example of a conservative business that grows as the economy grows. If it's managed well or if somebody wants to take it over, yes, you can have an extraordinarily good year, but we're not trying to hit home runs--in the Income Fund, especially.

Is the philosophy similar in the Growth Fund?

It's a little more aggressive; the biggest stock in the Growth Fund is Apple Computer [AAPL]. We're much more [invested] in technology and higher growth industries. The biggest industry would be technology. Apple is 3.9% of the portfolio, which is nice on days like yesterday, [July 26, when Apple held up when much of the market dropped]. They can still grow. The nice thing about Apple is they still are only 5% of the market [for] computers, and they're less than that in cellphones, so now they're going after the cellphone market; the MP3 player market, well, they invented that. The iPhone is just another iPod, really. They'll end up with several kinds of phones at different price points in the market--they came in with a $500 product but I'm sure within the year they'll probably have two more kinds that will be lesser priced that will be aimed at getting an even bigger share in the cellphone market.

One that we've invested in for a long time in both funds--it's unusual to have one in both funds--is EnCana [ECA], a Canadian oil company. Its two primary businesses are deep natural gas and tar sands oil in Alberta. Their real specialty is difficult-to-get stuff, high cost, and at these prices, obviously they're making good money. They own 7% of the tar sands and have current technology that can recover in the next 25 years or so enough oil to supply North America's needs, everything, for four years. People don't understand how much oil there is in Alberta--and it's coming to market. It's expensive; my guess is right now around $30 a barrel. It's a long-term growth holding, that's the kind of thing we're happy to keep.

Are there similar situations in the Income Fund?

FPL [FPL] is a company we've held for a long term, a typical Income Fund holding, one of the larger holdings in the fund. It's the old Florida Power & Light. The thing that really attracted us was a nice dividend, but [also] it's the biggest wind power company in the United States. FPL happens to have a lot of turbines out here on the Columbia River [in Washington state]; they have a lot in West Virginia. They started [by] having some nuclear reactors in Florida where there wasn't a lot of oil or gas that they could burn, so years ago they got into alternative sources.

One of the things that has worked for us is our international focus. We aren't just buying U.S. stocks. Of course, most companies do have a large international component if they're a big company, so you're really participating in the world economy. We have about 24% of each of the Amana Funds in what would be classified as internationals, headquartered outside the U.S., and getting primary earnings outside the U.S.

Is there a company that hasn't worked out for you?

Restoration Hardware [RSTO] is a small company in the Growth Fund that's not performed. We were looking for their sales to grow more than they did, and they just haven't been able to do that.

Do you have a sell discipline?

In general, ones that fail to operate well--miss their targets, miss expectations that we set up for them about how their business should be doing. It's not a short-term or arbitrary discipline; it's all earnings based, and very much on the fundamentals of the business.

Are you seeing money coming in from non-Muslim investors who find the fund attractive?

Yes. Most of our money today is coming from RIAs and the supermarket platforms, those accounts that they're managing, so the RIAs really are probably what's driving most of our sales today, based on performance--I'm sure it's what they're after. And I think they'd like to know what they're buying so we try to educate them so that they're not surprised when they read the annual reports.

One of the things we do in these funds is [have] a low turnover rate, about 9% this last year. We aren't traders. We also, as the investment advisor--because we have a discount brokerage--we do the brokerage but we don't charge any portfolio commissions so the funds save quite a bit of money; there's no hidden fees there, or expenses. We aren't using portfolio brokerage to benefit the advisor or get research or any of that kind of stuff. What we have been able to do is lower the expense ratio as we grow the funds.

Do you think you'll see more of an inflow from people looking to stay out of the financial sector?

I think so. People may decide, I've got enough bonds, and may be looking for some stocks; how do I find a fund that isn't in the financials, because I want to be diversified. Many times I think you would say: Okay, well, Amana--they're not totally diversified, and there's an extra risk there from not having the financials, but there's also a risk from having the financials, and especially if you've covered that diversification need with something else in your portfolio.

Do you have a typical investor?

I think a long-term equity investor who's looking for that extra safety of a large-cap income type portfolio, whereas in the Growth Fund it's a true equity investor. We're not chasers of start-up companies or risky investments. We've stuck with a value approach and that's protected us from a lot of the volatility that you often get in equity portfolios.